Gold and Inflation

April 12, 2004
CFA, Chairman of Prophecy Development Corporation

First we would like to clarify the term inflation and the cause of it.

We define inflation as the increase in the supply of paper money, or M3 in the modern world.

Popular press defines inflation as a general increase in the price level of goods and services.

It's more proper to say that inflation often causes price increases. However, in our opinion, it's only quasi-correct to say that inflation primarily causes prices to increase. Let us illustrate:

Now what is it would you say that caused the balloon to pop, the elasticity of the rubber, the needle or the air?

Since 1933, the quantity of paper money has grown tremendously. Let's assume a few points here:

Air inside the balloon = paper money
The balloon (i.e. rubber) = stocks and bonds (i.e. placeholders of paper money)

From the figure (and refer to chart a and chart b), you can see that the Fed has been blowing air for decades. While the balloon (i.e. the total size of stocks and bonds as placeholders) continues to grow, accommodating the new air, it is not growing fast enough. At some point the balloon will simply pop (sometimes with the aid of a needle). The air then spills everywhere (this is equivalent of commodities being showered with paper money) and there you have it: the story of hyperinflation.

Chart b. How much money there is today compared to that of 1970.

You can always get a handful of scholars to prove to you that the gold standard is "barbaric" and it thus was abolished in its entirety in 1972. The economic authorities cite inflexibility as the instability of the gold standard. Some even blame it as the cause for the 1930s depression.

Everything is possible. However, let us quote from "The Law" by Mr. Frédéric Bastiat of 1850.


But it is also true that a man may live and satisfy his wants by seizing and consuming the products of the labors of others. This process is the origin of plunder.



It takes painful labour to earn true wealth, and it takes no pain to change the law and create paper money out of thin air. So now you understand really why the gold standard was abolished completely in 1972. Any new international monetary law fixing money supply growth will not work without an anchor. The role of gold is here to stay.

Now to those economists of today who understand the law of supply and demand. Gold is USD $395 today. That's the equilibrium price established by a free market based on aggregate supply of demand for gold. So why is gold poised for a move?

To say gold is poised for a large move, we imply there must be a dramatic shift in the supply and demand of the metal.

Please review chart c and d. One thing should jump out at you:

Why did gold spike from $35 to $850 from 1971 to 1980?

This phenomenon can only be explained when:

  • A lot of above-ground gold disappeared from the earth, causing a supply shortage of gold. (not true)
  • Gold demand was fairly constant, however, officials in the 1970's grew the paper money supply by 20 fold, thus everything measured in dollars grew by 20 fold. (not true)

The only plausible explanation left is that there was a sudden surge in demand for gold in exchange for dollars in the 1970s. So what suddenly rushed people into gold? Getting out of the dollars?

The basic answer is that the intrinsic value of a dollar has almost always been zero. It takes nothing to print a dollar as noted by today's Mr. Bernanke.

Chart d.

In terms of market cycles, we view 2002 to be another 1970.

The dollar peaked and started its descent in 2002, similar to 1970, when the dollar started showing weakness.

We are 2 years into the dollar bear market. The dollar made a bottom in 1972, which was tested and broken almost 6 years later in 1978. It is then reasonable to expect the dollar to reach a multi-year bottom in 2004 which may not be tested for at least 2 years.

Commodity prices broke out in 1971. This is similar to what we saw in 2003 and matches nicely with our view.

Gold started rising in late 1971, almost 2 years into the start of the dollar bear. In the present period, gold started rising in 2001, ahead of the dollar bear. This is an interesting divergence. We think gold would have started rising as early as 1968 had the gold window be closed then. Gold is a relatively small market compared to currency markets. This means its price is more sensitive to investment demands. It makes sense to have gold making its bottom slightly ahead of the peak of the dollar.

If our comparison of the timelines has merits, then gold is ready to make a 300% gain in the next 3 years, similar to what happened from 1972 to1975, when gold moved from $50/oz to $200/oz. Given that gold had jumpstarted this time around with the absence of the gold window, we would still expect a 200%+ gain ($1,200/oz) by early 2007.

John Lee, CFA is an accredited investor with over 2 decades of investing experience in metals and mining equities. Mr. Lee is the Chairman of Prophecy Development Corporation. John Lee is a Rice University graduate with degrees in economics and engineering.


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